A firm's primary financial objective is to maximize shareholder value. The firm can increase shareholder value by investing in projects that yield a return greater than the cost of capital. Thus, the cost of capital is also referred to as a hurdle rate. The firm analyzes prospective projects through capital ·budgeting decisions, which involve discounted cash flow (DCF) analysis. The cost of capital should be the proper discount rate used in the DCF analysis.

The Logic of Weighted Average Cost of Capital

Though some firms are financed entirely with equity funds, most firms raise a substantial portion of capital with long term debt or preferred stock. To fiance a particular project, a firm may raise a particular type of capital (e.g., debt), and thus may use up some of its capacity for raising capital from that type. As the firm expands, it will need to raise additional capital from other sources (e.g., equity) to maintain its target weights of each capital type. Thus, the cost of capital must reflect:

The weighted average cost of the various types of capital the firm uses.

The firm's long-run target weights.

The Cost of Debt

The after-tax cost of debt is used to compute the weighted average cost of capital. It is the interest rate on debt (Kd) less the tax savings due to the deductibility of interest . In fact, the government pays part of the cost of debt because interest is tax-deductible.

The Cost of Preferred Stock

Preferred stock is a perpetuity that pays a fixed dividend. Preferred dividends are not tax-deductible. Therefore, there is no tax savings associated with the use of preferred stock. The formula for calculating the cost of preferred stock is:

Kp = Dp/Pnet

The Cost of Retained Earnings

Raising retained earnings has no direct costs. However, it involves an opportunity cost. ;. Shareholders could have received dividends from the earnings and made alternative investments. E So, firms should earn on retained earnings at least the rate of return shareholders expect to earn on alternative investments with equivalent risk. ;. Such an alternative investment is the firm's own stock. E Thus, the cost of retained earnings (Kr) should be the A expected rate of return of the firm's own cotnmon stock ( KJ. m Since stocks are normally in equilibrium, the required rate of return (Ks) is equal to the expected rate of return